My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Monday, September 8, 2014

Alibaba's coming out party: Valued right, but is it priced right?

As Alibaba's IPO approaches and the road show kicks into high gear, questions about its accounting, value and corporate governance that came up at the time of the filing of its initial prospectus on May 6, 2014, are resurfacing. Alibaba's banking team announced on Friday that their initial pricing for the stock would between $60 and $66 a share, giving the company an estimated an equity value of about $155 billion at the pricing midpoint. That would make it the most valuable IPO in history, much higher than the $80 billion at which Facebook's equity was priced at the time of its IPO in 2011 or the $25 billion at which Google priced itself in 2004.

Valuing Alibaba

I valued Alibaba in May 2014, right after their initial prospectus was filed in this post which I titled "Alibaba: A China Story with a profitable ending?". In that post, I argued that Alibaba's dominance of the Chinese online retail market provided a foundation for immense value, driven by the size of and the growth in that market and sky-high operating margins. While I will not repeat the specifics of the valuation here, the combination of high revenue growth, sustained margins and relatively low reinvestment, I argued, yielded a value of $145.6 billion for the company and a value per share of approximately $61/share.

Much has happened in the five months since: Alibaba has navigated its way through some accounting quicksand, rumors surfaced of an investment in Snapchat that valued the company at $10 billion though the deal fell apart, and Alibaba updated its prospectus to reflect an additional quarter of information. Since a few months can shift both the numbers and the narrative for a young company, I revalued the company on September 2, 2014 (it was the first valuation of the week in my Fall valuation class) using Alibaba's filing from August 27, 2014. While there a few tweaks to the valuation, my assessment of the company has changed little. The value of equity that I get, allowing for an initial offering proceeds of $20 billion, is $161 billion, with about half of the increase in value coming from a larger initial offering, and the value per share that I get for the company is about $66. The picture below captures my assumptions and you can contrast it with my earlier valuation from May, if you are so inclined:

In keeping with my posts on narrative and numbers, the key question is whether there is anything that has happened in the last few months that has changed my narrative of Alibaba as a dominant, profitable Chinese online merchandiser and the answer is 'not yet'. The reason that it is not an emphatic no is that some of the actions taken by Alibaba in the last few months, including a rumored investment in Snapchat, suggest that it has ambitions to become a global retail giant, competing with Amazon, Google and even Facebook. In the quarters to come, if these actions become more concrete and costly, I will revisit this valuation to see the effects, positive and negative, of this narrative shift.

I have a few emails in the last few days asking whether I feel vindicated by the fact that Alibaba's bankers seem to have arrived at a number very similar to mine and my reaction is mixed. First, given what I think about the valuations that emerge from investment banks in general, I am queasy that I am in agreement with their assessments of Alibaba's value. In fact, it is entirely possible and perhaps likely that both the bankers and I are hopelessly off track on our assumptions and that the true value is a number very different from our assessment. Second, and repeating a point I have made on prior posts about IPOs, bankers don't value companies in IPOs; they price them and the fact that they are thinking of pricing the company close to my estimate of value is, in my view, more coincidence than a reflection of consensus.

Pricing Alibaba
When asked to attach a number to an asset, I believe that you have to start with a fundamental question: Is your mission to attach a value to the asset or is to price the asset? If your job is to facilitate a transaction or get a deal done, as is the case with bankers in an IPO, you have a pricing mission and we would all save ourselves significant disappointment and disillusionment, if we remembered that. In effect, Alibaba's bankers have to price the stock for the IPO, not value it. To get to the right price for a company in an IPO, there are five key steps involved, though one of them is purely for external consumption.

Use pricing metrics and comparable firms to arrive at an estimate of what investors will pay for the shares: Those pricing metrics take the form of multiples of earnings, book value and revenues and the comparable firms are other publicly traded companies that you believe investors will compare your firm to. The process clearly has subjective judgments in it, in your choice of multiple, in what firms you include in your comparable list and how you control for differences. The table below provides the range of estimates of equity value that I obtain for Alibaba, depending on which multiple I use (PE, Price to Book Equity, EV/EBITDA, EV/Sales or EV/Invested Capital), what I choose as my comparable firms (Just Baidu, Online Advertising, Online Retail, Online Services or all Online companies) and how I compute my sector average (Simple average, Median, Aggregate values). I can get values ranging from $11.9 billion (using the EV/Sales of online advertising companies) to $944 billion (using the simple average PE ratio of Online service companies), and while this may strike you as absurd, it also points to why how easily relative valuations can be used to justify almost any point of view or sales pitch. With Alibaba, at least, it seems clear to me that if multiples are used in the road show, they will almost always be earnings-based (since you get much higher values with those than with revenues or book value) and that the comparable firms will be pruned to create a sample that makes Alibaba look cheap. You can download a spreadsheet that lets you alter the choices and one that contains the raw data on individual companies.

Alibaba Equity Value: Based on Trailing 12-month numbers. With EV multiples, I add cash and subtract out debt to get to equity value

Gauge demand: If pricing yields such a wide range of numbers for Alibaba, how do you arrive at a price for the initial offering? The answer is surprisingly simple. The bankers setting the price start by getting a measure of how much potential investors (especially larger ones) are willing to pay for the stock and gauging demand. If investors seem too enthusiastic at a specified price, they will move the price up, whereas a muted response will lead to a lowering of the price.

Build in the "pop": For better or worse, bankers are not feted for getting the price right but for getting it wrong, albeit in one direction and not by too much. A well-priced IPO is one where the stock jumps on the offering date by about 10-15%, relieving bankers of their underwriting responsibility, rewarding key clients (who were able to subscribe at the offering price) with a quick profit and providing press buzz and price momentum for the issuer to make subsequent offerings. I may be reading more than I should into Alibaba's initial pricing numbers, but the fact that the offering price is set at $63 ($155 billion) suggests to me that the bankers believe that a fair price for the stock is about $180-$200 billion.

Reverse engineer a "valuation" to back up your price: For some reason, bankers seem to believe that they have to cloak their pricing in a value framework, i.e., make it look like the price that they have arrived at is really the result of an intrinsic valuation. Thus, a DCF valuation is created, inputs are tweaked and first principles are often mangled to arrive at the desired number (from the first three steps). To be fair to bankers, this step in the process may be designed to prevent legal jeopardy, since courts seem to also think that due diligence in this process requires a DCF valuation.

Reassess demand: While we think of roadshows as designed to help the issuing company and its bankers make their sales pitch to investors, the information flows both ways, as investors' views and reactions can help bankers reassess their offering price range. The final offering price does not have to be set until the day before the offering date, leaving plenty of time for adjustments and readjustments.

After all of this effort on pricing, you would think that the bankers/issuing company would get it right, but as Facebook and Twitter illustrated in divergent ways, it is easy to get it wrong, with the offering price set too high for Facebook and too low for Twitter. As to how Alibaba will fare on opening day, your guess is as good as mine, but if the stock does jump about 15% on the opening day, the company and its bankers will celebrate a Goldilocks pricing moment.

Investing or Trading

Should you invest in Alibaba? At its estimated offering price of $150-160 billion, I think that it is a fairly-valued investment, if you can overcome two fears. The first is that, as a shareholder, you are not becoming part owner of Alibaba, the Chinese online merchandiser, but instead get a share of a shell entity (the Cayman Islands based variable interest entity) that controls the operating company through a legal agreement (that exists because the Chinese government treats it as such, for the moment). The second is that you are buying a corporate governance nightmare, where this will remain Jack Ma's company for the foreseeable future and you will have no say in what the company does, how it is overseen or its management decisions. I will return to the issue of corporate governance, why it matters and how best to incorporate it into value in another post. I, for one, will stick with my indirect investment in Alibaba, through Yahoo!, and hope that I get the spillover benefits.

Should you trade Alibaba? That will depend on whether you are good at playing the pricing game and I drew the distinction in this earlier post. Since I am not particularly good at this game, my advice on this count is worthless, but if you do play the pricing game, recognize that your capacity to make money will come from assessing investor mood and stock price momentum.

Anonymous 1,On the first one, you are right. I should have netted out the non-operating assets to get to capital. One reason I don't think it affects my valuation is because I used a sales to capital ratio of 2.00, well above even the 1.52 you get with the adjusted figures. The starting return on capital plays no role in this valuation, which is driven by revenue growth and operating margins.Anonymous 2,I do have YHOO still and have not sold it yet. If Alibaba goes public and the stock price pops, I will be tempted to, but I will wait and see.

I have not really seen their prospectus but what about profit splits? If their US Exposure rises and hence fall in margins then revenue weighted WACC may not be right. It will keep falling as non Chinese revenues go up but profit shares follow other direction. So if profit spilt is used as weights I guess WACC ERP should tend more towards China and hence higher WACC or lower NPV. I am also a follower of your book on valuations and you have some value for control. In this case control seems non existent by what I understand and hence a strong discount is justified. I say this since what the investor gets is holding in a shell company based in Cayman islands. So lack of any meaningful control should also be adequately discounted

I'd love to see his thoughts in pricing in the China governance risk eg how to price the risks innate in Chinese (and many other emerging economy) businesses, where you have not insignificant risks of the Party and government:

- Directing a Chinese business to act on political policy grounds rather than on purely profit-seeking grounds (bearing in mind that acting as the CCP wants you to act does avoid losing profits)

- Deciding they don't like some aspect of what you're doing and putting a stop to it - a more significant risk than the regulatory risk in Western systems

- Imposing regulatory curbs on Alibaba's potential growth (eg the restrictions Alibaba ran into with Alipay, as the government would not permit foreign ownership in areas of financial services)

- Cracking down on the current legal device used to circumvent foreign ownership restrictions in companies that hold Chinese internet content licenses

(and there are others)

I've seen some people address this through adding a risk premium to discount rates, but that doesn't make conceptual sense, as the discount rate is supposed to represent a non-diversifiable systemic risk perspective. Risks you can diversify away from through geographic diversification should, instead, be represented in probability weighted cash flows in a DCF analysis.

I'm very keen to hear how the Professor addresses the types of risks in his Alibaba valuation. Are they considered too far along the tail to incorporate? Or too hard to incorporate?

There is a range around every value estimate. Just as you don't buy a stock just because it has just fallen below your value, you don't sell it the minute it exceeds your value. And the value itself changes over time.

Could you kindly update your valuation of YHOO based on the newer estimates of Alibaba? I think your prior valuation estimate of YHOO is a little low at $39 due to the more rosier valuation of BABA.

My sum-of-the-parts valuation of YHOO points of $48/share with low and high ranging from $46.35-$50.10.

For core YHOO, i use a 9.5x EBITDA multiple for its 2014E EBITDA. A market cap on YHOO Japan of $22.35 billion. And a market cap of BABA ranging from $190B-$210B.

Would love to hear your thoughts, and see your updated valuation. I think the valuation of Alibaba is being very conservative, considering the sky-high EBIT Margins of the company (much higher than the next biggest Internet comp, Facebook).

Hi,Post the Alibaba IPO, Yahoo will get some money from the sale. I am wondering how the share price will behave after that event. Should it not be a function of the ROE on that cash. Suppose Yahoo left that cash in the bank and did nothing, then clearly its value would depreciate over time. If Yahoo chooses to invest it, then we should do a DCF of that investment instead of assuming it is cash right?

Aswath: Thanks for offering your valuation thoughts in a public forum. With regard to YHOO I expect it will sell off in the couple days before and after the BABA ipo. This is based on my own casual empiricism as a trader. A stock doing a high profile IPO spinoff tends to get bid up in the period leading up to the IPO but once the IPO is done, traders/investors lose interest in the parent stock since they can own the spinoff instead. Maybe there are academic studies of this phenomena but I am not aware of any.

First, would like to thank you for your insightful and helpful posts on corporate finance, been reading your blog for quite some time. I'm an undergrad economics student in Brazil with an interest on Corporate Finance and your blog made me enjoy the subject a lot more.

Besides your article on valuing young growth companies, would you know of, or recommend, any other articles on the valuation of start-up and growth companies, or authors who have done something related in the past?

Dear Prof, Thanks for your efforts and the way you introduce the valuations topics, you really make it interesting. I have a new exercise for you - if interested. This week one of the largest IPO in the Middle East is coming to Dubai - UAE. Emaar Properties - the developer of the highest tower on the world will float its Shopping Malls Unit - which actually Dubai Mall - the largest Mall on the world - The prospectus will be issued on Sunday and we would thankful if you can show us your magic valuation fingers and see how to value such IPO. It is unique in nature and business model. Waiting for your contributions.

Professor: I appreciate that you're using the 27% CAGR that Alibaba estimates for China ecommerce. But Alibaba also claims they are 8% of retail transactions in China. That seems like a ridiculously high growth rate for one company that already claims a disproportionate share of an economy....

If you assume the Chinese economy grows at a 7% CAGR for the whole period of your valuation, and that retail as a whole in China grows in line, you'd have to believe that Alibaba will control 24% *of Chinese retail transactions* by 2020. Not just online transactions, but all retail transactions.

It seems like they are right against the ceiling of believability. Either ecommerce has to explode as a % of overall retail (in a country with bad internet, bad roads, bad logistics) or Alibaba somehow needs to drastically increase its take rate on the transactions it's fostering (while somehow not inviting competition).

I realize you're just using the numbers provided and the valuation methodology is very sound, but aren't the provided growth figures unbelievable?

Prof DamodaranHow does share buyback impact valuation? For instance, after the Alibaba IPO if Yahoo uses the cash to buyback shares, it should theoretically reduce the marketcap since cash is used to do the buyback. Prior to the buyback, the DCF value of Yahoo would include the value from Alibaba. Post buyback, this DCF value should reduce by the amount of buyback. Now, even though shares outstanding have come down, the intrinsic business value has not changed but overall DCF value is down. So, how is this good for shareholders

I have a very basic question. How does a firm (or Alibaba in this case) decide on the number of shares to sell. It seems like the price and the shares are jointly determined. One can sell more shares if the demand is high (and hence offer lower price) or less shares if the demand is low (and hence offer a higher price and hence a lower first day pop). I checked your spreadsheet and you have a note there talking about how to get the number of shares but I don't understand why the CEO/CFO cannot say...well, we would like to sell 50000 more shares by creating them out of thin air (and dilute the standing of everyone else or increase their stakes proportionally).